Currency Derivatives

Currency derivatives are exchange-traded contracts that derive value from a currency. Investors trade specific currency units at a set date and rate.
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Currency Derivatives
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3 min
19-July -2024 

Currency derivatives allow businesses and investors to trade currency pairs. Some major currency pairs are USDINR, EURINR, GBPINR, and JPYINR. These contracts are widely used to hedge against changes in currency values and to earn profits.

Let us understand the currency derivative definition, types, and practical usage through examples.

What is currency derivative?

A currency derivative is defined as a futures or options contract between two parties in which one currency can be exchanged for another at a pre-determined rate on a future date.

These contracts derive their value from the exchange rate between the two currencies. Derivative trading is primarily used for:

  • Hedging against currency risk or
  • Studying on the currency movements without directly owning the underlying currency.

Why was the currency derivative introduced on exchange platforms?

Before currency derivatives were available on exchanges, individuals relied on the over-the-counter market to hedge against currency volatility using negotiated contracts.

The market was initially a closed one and mainly used by banks and financial institutions for trading. However, the exchange-based currency derivatives market is now highly regulated for transparency. It is accessible to individuals and small businesses and individuals who seek to minimise their currency risks.

Examples

Example I

When used as a hedging tool (using currency forward contracts)

The scenario

  • An Indian company plans to import goods worth $100,000 from the United States.
  • The current exchange rate is 1 USD = Rs. 75
  • Based on it, the total cost in INR would be 100,000 * 75 = Rs. 75,00,000

The concern

  • As per the company’s anticipation, the USD might strengthen against the INR by the time they need to make the payment.
  • This weakening of INR could increase their costs.

The hedge

  • To hedge against this risk, the company enters into a forward contract with a bank.
  • They agree to buy $100,000 at a predetermined exchange rate of 1 USD = 75 INR, which is the current rate.
  • The forward contract specifies that the exchange will happen in three months when the goods are delivered.

The outcome

  • After three months, that is, on the date of making payment, two scenarios can unfold:
Scenario I: The exchange rate remains the same at the time of delivery Scenario II: The USD appreciates against the INR at the time of delivery
The company buys $100,000 at the agreed rate of 1 USD = 75 INR.They pay 100,000 * 75 = Rs. 75,00,000 as per the forward contractThe total cost remains the same, and the company avoids losses due to currency fluctuations. The USD appreciates to 1 USD = 80 INRWithout the forward contract, the company would need to pay 100,000 * 80 = Rs. 80,00,000 INR for the goods.However, because of the forward contract, they still buy $100,000 at the agreed rate of 1 USD = 75 INR.They pay 100,000 * 75 = Rs. 75,00,000 and save Rs. 5,00,000 compared to the spot rate.Even though the exchange rate moved against them, the company is protected from losses because they locked in a favourable rate with the forward contract.


Example II

When used for trading purposes (using currency call options)

The scenario:

  • An Indian investor expects the Euro (EUR) to strengthen against the Indian Rupee (INR).
  • The current exchange rate is 1 EUR = Rs. 90.
  • The investor decides to purchase EUR/INR currency call options with the following details:
    • Strike price: 1 EUR = Rs. 95
    • Expiration: Three months from now
  • This call option gave the investor a right, but not the obligation, to:
    • Buy a specific amount of EUR
    • At 1 EUR = Rs. 95

The outcome

After three months, that is the period after which the futures contract expires, there could be two possible scenarios:

Scenario I: The EUR appreciates against the INR Scenario II: The EUR does not appreciate or depreciate against the INR
The currency exchange rate is 1 EUR = Rs. 100The investor exercised the call option.They bought EUR at the predetermined strike price of 1 EUR = Rs. 95.Then they immediately sold the EUR in the spot market at the higher rate of 1 EUR = Rs. 100.By exercising the option, the investor profits from the difference between the:Strike price andSpot rate. The investor is not obligated to exercise the option.They chose not to exercise the option and incur only the initial cost of purchasing the options contract.

 

What are the different types of currency derivatives

As observed earlier, currency derivatives play a crucial role in managing currency risk and facilitating profits. Let us have a look at some of their common types:

Currency futures

  • Currency futures are contracts where two parties agree to exchange a specific amount of one currency for another currency.
  • This exchange happens at an agreed-upon price (the futures price) on a specified future date.
  • These contracts are standardised and traded on exchanges.
  • This accessibility makes them accessible to a wide range of investors.
  • Currency futures are commonly used for:
  • Hedging currency risk or
  • Trading on future currency movements

Currency forwards

  • Currency forwards are similar to futures contracts but are customised by the two involved parties.
  • Unlike futures, forwards are traded over-the-counter (OTC) and are a type of OTC derivatives.
  • This OTC trading allows for greater flexibility in terms of:
    • Contract size
    • Expiration date, and
    • Other terms
  • They are commonly used by businesses to hedge against currency risk in international transactions.

Currency options

  • Currency options give the holder the right, but not the obligation, to:
    • Buy (call option) or sell (put option)
    • A specific amount of one currency for another currency
    • At a predetermined price (the strike price)
    • Within a specified period (until expiration)
    • They are widely used for generating and generating income through option premiums.

Currency swap contract

  • A currency swap contract involves the exchange of principal and interest that are denominated in different currencies.
  • A currency swap contract envisions the following:
    • At the offset of the contract: Exchange of equivalent principal amount at the spot rate between two parties.
    • During the contract tenure: Payment of interest on the swapped principal amount by the parties.
    • At the end of the contract: Swapping of the principal amount either at the spot rate, a pre-determined exchange rate, or the original rate for the principal exchange.
  • This contract can be considered an over-the-counter contract and is tailored to suit the unique needs of the contracting parties.

Benefits of currency derivatives

Currency derivative trading offers a range of benefits to investors, such as hedging against exchange rate fluctuations and leveraging arbitrage opportunities in the currency market.

Hedging

Trading currency derivatives to a hedging position allows traders to protect their investments from foreign currency exposure and fluctuations. Investors typically trade currency options to hedge against potential losses from currency fluctuations. Even importers, exporters, and institutions participate in hedging to maximise profits or reduce losses due to fluctuating interest rates.

Trading

Traders trade currency derivative contracts with the goal of capitalising on short-term fluctuations in forex markets. They often employ different strategies to yield high profits.

Arbitrages

Particular markets do not restrict traders from capitalising on price discrepancies of a certain currency pair in different markets. This concept is known as currency arbitrage, wherein a buyer buys a currency pair and sells it instantly in another market for a higher price.

How can you trade in currency derivatives?

Trading in currency derivatives is very similar to trading in equity and its derivatives. In India, stock exchanges like BSE and NSE have segments dedicated to currency derivatives. While the Metropolitan Stock Exchange of India also offers a similar segment, the volumes are significantly lower than those of the BSE and NSE. Investors also have the option of choosing a broker for assistance in currency derivative trading. Trading can be carried out using a broker’s trading app. Essentially, all leading stockbroker firms provide currency trading services.

Conclusion

A currency derivative is a contract between two parties to exchange one type of currency for another at a set price on a specific date in the future. It exists in various types, such as currency options, currency futures, and currency forwards. Primarily, currency derivatives are used for hedging against currency risks and for earning profits.

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Frequently asked questions

What are currency derivatives examples?
Two common examples of currency derivatives include currency futures contracts, which obligate parties to buy or sell a specified currency at a predetermined price and date, and currency options contracts, which give the holder the right to buy or sell a currency at a predetermined price within a specified period.
How do you trade currency derivatives?

Currency derivative trading operates in a similar way to stock futures and options trading, with the distinction being that it involves currency pairs (such as EURINR or USDINR) as the underlying assets instead of stocks. Currency futures and options trading is carried out on Foreign Exchange (Forex) markets, where the forex rates dictate the value of a foreign currency against the domestic currency. The key participants of currency trading in India include banks, corporations, exporters and importers.

What are some common uses of currency derivatives?

Currency derivatives are commonly used for hedging against currency risk and studying currency movements.

How do currency derivatives differ from traditional forex trading?
Currency derivatives involve contracts with predetermined terms and standardised sizes. On the other hand, traditional forex trading involves over-the-counter transactions in the spot forex market.
What are the different currency derivatives?

There are four main types of currency derivatives: options, futures, forwards, and swaps. In India, currency derivative trading is permitted in currency pairs, such as USD/INR and EUR/INR, and cross-currency pairs, such as EURUSD and GBPUSD, which act as underlying assets.

What are the differences between currency derivatives and equity derivatives?

Buying equity derivatives in the cash market means that you expect some movement (up or down) in the underlying equity index or stock. However, buying currency derivatives means you expect the dollar to either appreciate or depreciate against the rupee.

What are foreign currency derivatives?

Foreign currency derivatives can be defined as financial instruments whose payoff value is dictated by the foreign exchange rates between two or more currencies. These derivatives are often employed for currency arbitrage or to hedge against foreign exchange risks.

What is currency derivative in simple words?

Simply put, currency derivatives are financial contracts that derive their value from their underlying asset, which is the currency. An investor buys or sells certain units of fixed currency on a pre-determined rate and date. These contracts are actively traded on stock exchanges and used widely by importers and exporters to hedge against domestic currency fluctuation.

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